Extend and Pretend: Manufacturing a Minsky Melt-Up

A distracted and preoccupied amateur is no match for a determined, organized
professional with a strategy. Though the collapse of the shadow banking system
was a near fatal miscue for the global bankers, they have been quick to adjust
their strategy. With an army of MBAs, quants and lobbyists they have reworked
their strategy at the expense of the still comatose and shaken taxpayer.

It is the first anniversary since April 2nd when FASB 157 was suspended and
with it the suspension of 'mark-to market' accounting. The US congress held
a gun to the head of the Financial Accounting Standards Board a year ago. Congress
left FASB no choice but to change their guidelines under the perception that
it was a deferral, allowing time for the banks to adjust the toxic and devalued
assets on their books. Where are we a year later with Mark-to Market still
'on hold' and Mark-to-Myth endorsed by the Federal Reserve Bank examiners?
Frankly, the 'happy face' media doesn't want to talk about it, so I will. As
an investor, unlike politicians and the media, I must face reality or I will
pay the ugly consequences.

In January's EXTEND & PRETEND
- An Accounting Driven Market Recovery, I outlined the accounting changes
that had been implemented to ignite a market reversal and rally from the
March 2009 low. These accounting changes ranged from the deferral of FASB
157 in March 2009, the Commercial Real Estate Loan Workout Policy in October
2009, the three cauldrons easing in November 2009, the deferral of FASB 166
and 167 in December 2009 and the System Wide Federal Bank Examiner Reinforcement
Training in January 2010. The changes were executed in a controlled and almost
militaristic operation. The market has reacted with a 58.4% retracement of
the 2008 decline and a 70% increase from the lows in the DOW industrial,
trumpeted eagerly by the nightly news. This was Stage I.

Before we discuss Stage II, which will be the manufacturing of a "Minsky Melt-Up",
let's briefly review the extent to which Stage I has created distortions in
the accounting of public traded financial fiduciaries. We will then be able
to see clearly how they have created the launch pad for Stage II.

STAGE I - AN ACCOUNTING ORCHESTRATED RALLY

The Friday Night Lottery

Almost every Friday night the FDIC seizes from 1
to 5 local or regional banks as insolvent failures. Saturday morning
we wake to find these bankrupt banks have been magically merged with another
bank. It all seems so normal. But does that speed and ease sound realistic
to you?

I am constantly amused by those people who claim there is some vast "conspiracy" in
this country when it comes to banks, balance sheets, and fraudulent lending
and accounting. There is no conspiracy. It is, in fact, "in your face" fraud.
The FDIC does us the courtesy of explaining it virtually every Friday night, right
on their web page. I am simply going to take last night's bank closures,
which numbered four. One of them has no "deposit insurance fund" estimated
loss available, because they didn't find someone to take the assets - they're
just mailing checks. But the other three do.

1- Waterford
Bank, Germantown MD: $155.6 million in assets, $156.4 in insured deposits.
They were "underwater" by $800,000, right? Wrong: Estimated loss, $51
million. That is, the assets of $155.6 million were overvalued by
approximately 30% at the time of seizure.

2- Bank
of Illinois, Normal IL: $211.7 million in assets, $198.5 million in
deposits. They were "underwater" by $13.2 million (which is why they were
seized), right? Wrong: Estimated loss $53.7 million. That is, the the
assets of $211.7 million were overvalued by more than 25% at the time
of seizure.

3- Sun American
Bank, Boca Raton FL: $535.7 million in assets (so they claimed anyway),
$443.5 million in total deposits. Heh, why did you seize them - they have
more assets than liabilities? Oh wait: Estimated loss: $103.8 million,
so the actual assets are worth $443.5 - $103.8, or $339.7 million. That
is, the assets of $535.7 million were overvalued by a whopping 37% at
the time of seizure.

This isn't new, by the way. In
August of 2009 I went through Colonial Bank's failure based on BB&T's
presentation to its shareholders on the "merger" - and gift it was given
by the FDIC. It too showed that Colonial had been carrying assets on their
books at a ridiculous 37% above where BB&T ultimately marked them as
a whole.

Folks, your bank is being assessed deposit insurance premiums to pay for
these losses. You are paying these losses through increased
fees and interest expense on your credit cards and all other manner of borrowing. You
are paying for outrageous, pernicious and endemic balance sheet fraud. There
is no conspiracy. It is right under your nose. One of these three banks,
based on their balance sheet, wasn't even underwater - it was "to the good" by
nearly $100 million dollars. The balance sheet was a flat, bald-faced
lie. You want to sit for this? Why should you?

Why should we believe they are not? You can go through more than a year's
worth of FDIC bank seizure information and in essentially every single
case you will find that overvaluations of somewhere from 20-50% have
in fact occurred, yet not one indictment for book-cooking has issued.

So let's be generous and assume that the "big banks" are over-valuing their assets
by 25% - the lower end of the range of what the FDIC says is, through actual
experience, what's going on, and add it all up.

The FDIC's experience with seizing banks thus far suggests quite strongly
that all four of these entities are lying about these valuations, and that
were they to be seized the loss embedded in them (and for which you, the
taxpayer would be responsible) is somewhere between $1.49 and $2.99 trillion
dollars.

Incidentally, neither the FDIC or Treasury happens to have either
$1.49 or $2.99 trillion laying around, and it is highly questionable if
they could raise it, should that become necessary. Now of course neither
you or I can prove this is correct. However, we can look at the FDIC's
own published bank closing statements, and derive from them a pattern stretching
back more than a year now that has disclosed that in essentially
each and every case the banks in question have overvalued their
assets by anywhere from 20-40%, and that as of the day of the seizure such
an overvaluation was in fact a continuing and ongoing practice. (1)

If you were a bank, why would you lend to small business or the consumer with
their inherent risks when you could play the Friday Night Lottery? As A bank
CEO you would ensure that you have plenty of cash ready to buy and take over
the depositors (whose assets you desperately need), while having most of the
bad debt written off and then likely getting very favorable FDIC guarantees
for quickly taking the banks off FDIC's highly depleted balance sheets. I imagine
every US bank CEO & his/her Board of Directors watch these results closer
than the March Madness basketball rankings!

To facilitate these bankrupt banks being taken over so quickly, there is obviously
a considerable amount of very secret negotiations (non transparent, non
public bidding) taking place behind the scenes. Like we saw with TARP (Troubled
Asset Relief Program), it is amazing how much money gets spilled when everyone
is in a frenzy to feed at the government trough.

It's Only Going to Get Worse

The biggest financial issue with local and regional banks is their commercial
real estate loans with building and construction loans being the worst.

The official government stance as stated in the February
report from the Congressional Oversight Panel makes for sobering reading.
It forecasts $200 to $300 billion in losses coming from commercial real estate
(CRE) loans. The report notes these were not considered in the famed stress
tests, since that process looked only through 2010, when the losses from
CRE will peak later. It outlines that:

Between 2010 and 2014, about $1.4 trillion in commercial real estate loans
will reach the end of their terms. Nearly half are presently underwater,
that is the borrower owes more than the underlying property is currently
worth.

Commercial property values have fallen more than 40 percent since the beginning
of 2007.

Increased vacancy rates, which now range from 8 percent for multifamily
housing to 18 percent for office buildings, and falling rents, which have
declined 40 percent for office space and 33 percent for retail space, have
exerted a powerful downward pressure on the value of commercial properties.

The largest commercial real estate loan losses are projected for 2011 and
beyond; losses at banks alone could range as high as $200-$300 billion.

The stress tests conducted last year for 19 major financial institutions
examined their capital reserves only through the end of 2010. Even more significantly,
small and mid-sized banks were never subjected to any exercise comparable
to the stress tests, despite the fact that small and mid-sized banks are
proportionately even more exposed than their larger counterparts to commercial
real estate loan losses.

A significant wave of commercial mortgage defaults would trigger economic
damage that could touch the lives of nearly every American.

Empty office complexes, hotels, and retail stores could lead directly to
lost jobs. Foreclosures on apartment complexes could push families out of
their residences, even if they had never missed a rent payment. Banks that
suffer, or are afraid of suffering, commercial mortgage losses could grow
even more reluctant to lend, which could in turn further reduce access to
credit for more businesses and families and accelerate a negative economic
cycle.

It is difficult to predict either the number of foreclosures to come or
who will be most immediately affected. In the worst case scenario, hundreds
more community and mid-sized banks could face insolvency. Because these banks
play a critical role in financing the small businesses that could help the
American economy create new jobs, their widespread failure could disrupt
local communities, undermine the economic recovery, and extend an already
painful recession.

ELIZABETH WARREN: Oh golly -- 2,988 banks that by the terms of their own
regulators are too concentrated in commercial real estate. These are the
medium size banks. By the end of this year, half of all commercial real estate
loans will be underwater, and they are coming in '11, '12 and '13.

The reason this is such a bad problem anyway -- think about that, nearly
3,000 banks out of a total of 8,000 -- it's the very banks that do small
business lending who are about to get socked in the nose on real estate,
commercial real estate losses.

CHARLIE ROSE: So we'll see banks going under because they've got too many
loans out there are not being repaid?

ELIZABETH WARREN: We're seeing banks that don't want to lend because they
see every dollar that comes in the door and say "I've got to hold on to it
to try to fill my commercial real estate hole or else I will be gone."

Home Equity Loans (HELOCS)

I find it amazing that with all the talk about government programs to keep
people in their foreclosed homes, with government incentives to increase home
sales, with new home construction at a near standstill and home prices finally
reaching some sort of bottom (near term), we never talk about the billions
of Home Equity Loans that were taken out from 1996 onward. Does it pass your
common sense test that people would stop paying their mortgage, car payments,
credit cards and yet still pay their Home Equity Loan? I don't think so. But
the banks have written down next to nothing here. This is the issue with Mortgage
write-down. If you write down the mortgage, by definition the Home Equity Loan
is now a 100% write-off. Ouch! Doesn't anyone remember this graph which was
so prevalent only a few years ago?

This is an absolute huge problem and is presently being hidden behind all
the mortgage foreclosure coverage. Amherst Securities, according to Reuters,
has said "commercial banks hold approximately $767 billion of the total $1.05
Trillion of second mortgages outstanding, with the Big 4 holding over $400
billion alone." Reuters estimates
that if the banks mark down the entire portion of home equity debt that exceeds
home value values, the net of estimated reserves would be:

If we were to write down these unsecured home equity lines by only 40%, then
the potential increase in regulatory capital for these 4 banks increases by:
$3.1B for Wells Fargo, $1.3B for JP Morgan, $2.1B for Bank of America and $1.0B
for Citigroup. Nothing is being done, nor is anything being forced by Federal
Reserve Bank examiners to be done.

I could go on about shadow housing inventory, 'jingle' mail and 'strategic
defaults', the python in the pipe with Option-ARMS, the failure of HAMP etc.,
but I am sure you have heard all you want to hear about housing to know the
banks have yet to effectively address the issue. Like landmines the issues
still lay on their balance sheets.

Because of this situation, the banks still minimally require 40% higher collateral
values. So how are they going to get it?

STAGE II -- MANUFACTURING A MINSKY MELT-UP

My grandfather, who was proud to keep his farm during the depression, had
an expression that I haven't heard in a long time. He was fond of warning that: "Banks
lend you an umbrella when it is sunny and then demand it back when it starts
to rain!" It has been a long time since we have had a 'rainy' economy for any
protracted period of time, but to this prairie farm boy the economic weather
forecast doesn't look that good.

We therefore need to remember some basics of banking. First, banks make money
borrowing short and lending long. This strategy is inherently risky. This is
why banking requires extensive regulatory laws and ever vigilant bank examiners.
Neither are to be 'tampered' with, which our politicians now seem oblivious
to.

Secondly, inflation and deflation are different for banks. The Consumer Price
Index and how much food, energy, consumer staples etc have increased is not
highly relevant to banks. Inflation or deflation to banks is about asset price
increases or decreases. It is about whether their collateral positions are
increasing or decreasing. I don't mean to be too simplistic here since cost
of money is critically important, but it serves to make the point that bank
strategy is driven by their view of the direction of asset prices and whether
their loans are covered, their capital ratio requirements are secure or what
a new risk adjusted loan is worth to them. What does the chart below say about
where banks view asset prices to be headed?

Banks need asset values to continue to climb. Now that the markets have reached
'nose bleed' levels and appear to be at the stage of looking for a consolidation,
the banks need another strategy to ignite asset prices further. The banks must
see higher asset prices to have any hope of achieving satisfactory Capital
Ratios with the known amounts of bad and toxic debt still on their books. Is
it any wonder banks are now making their profits primarily in their trading
operations driving asset prices higher and with their Interest Swap where they
are squeezing collateral call levels? (see: SULTANS
OF SWAP: The Get Away!)

MANUFACTURING A MINKSY MELT-UP

If the banks wanted to get collateral values up, and manufacture a 'Minsky
Melt-Up' here is what some of their strategy elements would call for:

1- Have the Federal Reserve reduce Fed Funds Rate to Zero

Done

2- Have the Federal Reserve hold down rates for a historic length of
time i.e. a "very extended period"

I am not saying that a successful Minsky Melt-Up will be achieved or in fact
could be successfully manufactured. Frankly, I would be very skeptical if it
weren't for the fact that former Federal Reserve Chairman Alan Greenspan specifically
said this could not happen (He also stated that market bubbles could not be
identified by the Fed nor addressed with Monetary Policy (yeh right)).
His views have typically been my contrarian indicator which has given me an
investment edge over the years. Before reading Alan Greenspan's 'Greenspeak',
consider that we presently have unstable economic policies, risk premiums have
been high and the Fed has successfully inflated a bubble in the Bond Market
over the last 20 months through QE (Quantitative Easing).

...Greenspan said "because the markets themselves are asymmetric: they melt
down, but don't melt up!" Mr. Greenspan argues:
(1) the ironic result of successful stabilization policies is a journey to
excessively-thin risk premiums, and if
(2) history has not dealt kindly with the aftermath of protracted periods
of low risk premiums, and if
(3) asset prices do not tend to melt up but do tend to melt down, then
(4) logic implies that the fattest fat-tailed secular risk to price stability
is deflation, not inflation.

How so? If bubbles are the ironic externality of successful stabilization
policies, then those policies can be successful only so long as there are
asset classes that the central bank can inflate into a bubble. When there
are no more free and clear assets to lever up, the game ends in a debt-deflation.
As the great Hyman Minsky intoned, stability is ultimately destabilizing!
That is the logical consequence of too-successful inflation stabilization.
Don't call it a conundrum, but rather a dilemma, if the Fed were to set and
achieve a too-narrow target zone for inflation. (2)

If according to Hyman Minsky, protracted periods of market stability leads
to instability and a market meltdown, does this preclude therefore that protracted
periods of market instability negate the possibility of a market melt-up (per
Greenspan)? I intentionally phrased the logic for this argument in perfect
'Greenspeak' fashion so we can all remember exactly how we got ourselves into
this global predicament in the first place.

CONCLUSION

This is a well executed strategy. It has been almost militaristic in its execution
- all the elements from a solid communications program (i.e. CNBS hype), accounting
and regulatory changes (FASB 157, 166, 167 deferrals et al ), government statistics
(does anyone actually still believe the CPI, Labor Report or other government
statistics any more?), and public's sentiment through the controlled market
perception barometer pumped at them every evening on how well the DOW Industrials
are doing. The US economic and financial situation has now reached a point
where the potential crisis could be referred to by our government interventionists
as a matter of national security. This is precisely why I am leaning towards
a Minsky Melt-Up being successfully manufactured.

There is an old market saying: "Don't fight the Fed!" This market
guideline has never been truer. In fact today it is more appropriate to say:

Gordon T. Long has been publically offering his financial and economic writing
since 2010, following a career internationally in technology, senior management & investment
finance. He brings a unique perspective to macroeconomic analysis because
of his broad background, which is not typically found or available to the
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Mr. Long was a senior group executive with IBM and Motorola for over 20 years.
Earlier in his career he was involved in Sales, Marketing & Service of
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Manager, Four Phase (Canada); Vice President Operations, Motorola (MISL -
Canada); Vice President Engineering & Officer, Motorola (Codex - USA).

After a career with Fortune 500 corporations, he became a senior officer of
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CBEX), where he spearheaded global expansion as Executive VP & General
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In 1995, he founded the LCM Groupe in Paris, France to specialize in the rapidly
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Mr. Long presently resides in Boston, Massachusetts, continuing the expansion
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Gordon T. Long is a graduate Engineer, University of Waterloo (Canada) in
Thermodynamics-Fluid Mechanics (Aerodynamics). On graduation from an intensive
5 year specialized Co-operative Engineering program he pursued graduate business
studies at the prestigious Ivy Business School, University of Western Ontario
(Canada) on a Northern & Central Gas Corporation Scholarship. He was subsequently
selected to attend advanced one year training with the IBM Corporation in
New York prior to starting his career with IBM.

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